The Fed Discusses a Formal Inflation Rate Target
Policy + Politics

The Fed Discusses a Formal Inflation Rate Target


With short-term interest rates stuck at their lowest possible level, Federal Reserve officials meeting today and tomorrow have once again been discussing a possible policy change some believe might help nudge the economy ahead: a formal inflation target. They hope that would make markets even more confident the central bank will not let inflation get out of hand.

Bernanke and most other Fed officials believe keeping expectations of future inflation stable is key to preventing a short-term surge — such as the current one related to the jump in oil prices — from influencing both business and consumer behavior in ways that could make inflation worse. For instance, a company might decide it could raise prices without strong customer resistance because they more or less expected it to happen.

But the idea of a formal inflation target has been rejected several times in the past and it’s uncertain what will come out of these discussions. The Fed isn’t expected to announce any new measures in its statement at the end of the two-day meeting.

The Fed already comes close to having an informal inflation target: All Federal Open Market Committee participants make quarterly forecasts that include a number for where they would like to see inflation several years in the future. In April, most of them suggested a 1.6 percent to 2 percent rate.

Many other central banks, including the European Central Bank and the Bank of England, have formal targets. And adoption of one by the Fed might calm some of its conservative critics in Congress who would like to change the Fed’s dual mandate of maximum sustainable employment and stable prices to just a focus on inflation.

But there probably would be an outcry from more liberal members of Congress if the Fed were to appear to be sharpening its focus on inflation at a time when unemployment is above 9 percent and not likely to fall swiftly.

Fed officials are unhappy about the lack of progress in bringing down the nation’s stubbornly high jobless rate, but aren’t likely to undertake new moves to spur the economy’s slow growth. The Fed will complete, as planned, its purchase of $600 billion of longer term Treasury securities by the end of this month – the so-called QE2 initiative – with no commitment for further purchases, as some critics have urged. The policymaking group, the FOMC, plans to keep reinvesting the proceeds from maturing securities to maintain the size of its balance sheet, at its present $2.8 trillion

Fed Chairman Ben S. Bernanke has argued that it’s the overall size of the balance sheet that provides significant support to the economy by helping keep longer-term interest rates lower than they otherwise would be. At a press conference immediately after the last FOMC meeting in April, Bernanke said that a decision to stop reinvesting those proceeds and thus letting the balance sheet shrink would be a sign the Fed had decided to tighten its policy stance.

Meanwhile, the FOMC will keep its target for overnight interest rates effectively at zero. The fact that that target cannot be reduced is the reason the Fed turned to other extraordinary measures, such as buying the Treasury securities, to help the economy. For instance, lower long-term interest rates have pushed down rates on home mortgages and made borrowing for business investment less costly.

Japan’s Economy and the Price of Oil
Bernanke and several other officials have said that part of the slowdown in growth this year is due to  economic problems in Japan, following the major earthquake and tsunami there, and to the jump in the price of oil, which sent the cost of regular gasoline to more than $4 a gallon in many parts of this country. As oil prices moderate and manufacturing in Japan improves, U.S. “growth seems likely to pick up somewhat in the second half of the year,” Bernanke said.

Higher gasoline prices caused consumer price inflation to surge, leaving households with less money available to spend on other goods and services. “If the prices of energy and other commodities stabilize in ranges near current levels, as futures markets and many forecasters predict, the upward impetus to overall price inflation will wane and the recent increase in inflation will prove transitory,” the chairman said.

Because of this year’s slower growth and the forecasts that oil prices will stabilize or fall somewhat, many analysts who had been expecting the Fed to begin to raise interest rates — or at least being to shrink its balance sheet later this year — now think such a move won’t come until sometime in 2012 at the earliest.

“Traders are betting on the Fed to raise its target interest rate by August 2012, Fed funds futures contracts show. That compares with expectations for a December 2011 increase four months ago,” Scott Lanman of Bloomberg News wrote recently.

Related Links:
How the Fed Could Set Off a New Recession (The Fiscal Times)
Inflation Ahead? The Fed May Raise Interest Rates (The Fiscal Times)